One of the most important decisions you need to make on the road to a successful business is the choice of a legal structure. It largely determines the future of your company, its management structure, personal assets protection, tax treatment, etc.
In recent years, more and more entrepreneurs have chosen to form a limited liability company (LLC) instead of a sole proprietorship or partnership. But who knows whether creating an LLC will be a good choice? To answer this question, you need to do some research and consider all the pros and cons.
In this article we will show you a list of advantages and disadvantages of LLC compared to other business structures to make it easier for you to make your final decision.
What Is an LLC?
An LLC is a separate legal entity formed in accordance with state legislation for the purpose of conducting business. Forming an LLC requires at least one owner, and the maximum number of participants is not limited.
The hybrid nature of an LLC as a business structure is reflected in its peculiarities. On the one hand, it is similar to corporations, because it provides limited liability to its owners and the freedom to choose the tax treatment. However, an LLC has fewer formalities of a corporation, making it popular among the aspiring entrepreneurs.
On the other hand, an LLC has all the advantages of separate legal entities that have been registered with the state. Unlike a sole proprietorship or general partnership, an LLC is a legal entity and is not required to use the names of its founders for the name of the company. This unique combination of the characteristics of an LLC provides it with a structure and flexibility not available to other entities.
Pros of Creating an LLC
1) Personal Asset Protection
When thinking about their future business strategy, many entrepreneurs wonder how to protect their personal assets in the event of unforeseen circumstances. An LLC provides that option for its owners.
Regardless of the financial status of the LLC, personal asset protection guarantees that creditors cannot pursue personal possessions of its owner. This is the effect of the “corporate veil”. However, to maintain it, you must keep business assets separate from the personal assets of the members.
Unlike a sole proprietorship or general partnership, a Limited Liability Company operates a business on its own behalf. This means that it is liable for all its debts and obligations. Therefore, if you decide to start an LLC and ensure the separation of corporate and personal assets, then your real estate, car and money will be safe.
There are, however, some circumstances in which the limited liability company owners may be personally liable. As a rule, such circumstances include:
- Committing tax or loan fraud;
- Giving personal guaranty to for business loan or debt;
- Causing damage to the LLC or an individual.
2) Simple Formation and Maintenance
Even though they are both formal business structures, the process of forming an LLC is simpler and usually cheaper than forming a corporation. The procedures may differ from state to state, but generally, the steps for an LLC’s formation are as follows:
- Choose a name that complies with state law;
- Designate a registered agent;
- Draft and submit an Articles of Organization form for approval;
- Comply with current state requirements. Most of them require annual reports, for the purpose of providing up-to-date company’s contact info to the state.
If you know the right course of action in advance, then it is simple to form an LLC. In fact, filling in blanks and paying a fee is all you need to get the long-awaited registration documents for your own LLC.
3) Pass-Through Taxation Model
By default, the IRS treats an LLC as a business entity with a pass-through taxation model. This means that the duty to pay taxes “goes through” the company and falls directly on its members. Most multi-member LLCs prefer this option because it avoids double taxation related to additional costs.
At the same time, the LLC owner has the right to indicate that the company will be taxed as a corporation. This involves a choice between a C corporation or an S corporation.
An LLC as a C corporation: the profits are first taxed at the company level, and then taxed again when distributed among the members. In some cases it can be favorable, because it gives the right to get additional tax deductions or loans.
An LLC as an S corporation: a company does not pay taxes on its own behalf. All business profits and losses are reported on each owner’s or shareholder’s individual tax return instead and are distributed according to ownership shares.
Keep in mind that pass-through taxation does not relieve an LLC from paying:
- Self-employment taxes;
- Employment taxes;
- Franchise taxes (where applicable).
4) Flexible Management
In comparison to corporations and limited liability partnerships, the structure of an LLC is more flexible. You can see this even at the creation stage, because you can form either a single-member or multi-member LLC. MMLLC allows you to join an unlimited number of members.
When you expand the business structure or change the LLC members, as a rule, there are no difficulties.
Moreover, unlike corporations, an LLC does not have a mandatory internal management structure, so the owners can change it at their discretion.
Usually, if the formation documents and Operating Agreement do not state otherwise, the company is managed by the owners. This is convenient if your company is small, or if you want to fully control its work.
Large companies with several departments often hire professional managers. In this case, the right to make all the most important decisions remains with the owners, and the managers only ensure the day-to-day running of the LLC.
5) Flexible Payouts
LLC owners have complete freedom to distribute all corporate profits and losses. You can choose any option, agreed upon with the other members, and write it into the Operating Agreement. The main ways of distributing funds include the following:
- Split equally;
- In proportion to the contribution of each LLC owner to its capital.
Since every business is unique, the ability to change how profits and losses are distributed is very important. This allows the owners to customize the business to take into account the specifics of the LLC.
Cons of Creating an LLC
1) Self-Employment Taxes
If the limited liability company members did not indicate otherwise, the LLC is taxed as a partnership by default. The company is not required to pay corporate income taxes, but the owners are obliged to do it. In the eyes of the state, they are self-employed individuals, not employees. Therefore, the IRS requires LLC owners to pay self-employment taxes, which consist of Social Security and Medicare taxes. Its amount is determined by the amount of profits earned from conducting business and is calculated at a rate of 15.3%.
2) Formation and Maintenance Fees
The cost of starting and maintaining LLCs is higher than that of sole proprietorships or general partnerships, which are not formal business structures. However, compared to corporations, LLCs are still less expensive because the cost of their registration is lower as well as the number of requirements.
The cost of the fees required to form an LLC depends on the state where you plan to operate. In some states it will cost only $50, while in others it can be as much as several hundred dollars.
In addition, you may be required to pay annual report fees, which are also determined by state law.
3) Paperwork and Record-Keeping
An integral part of forming an LLC and maintaining its operation is paperwork, a mandatory part for both multi-member and single-member companies. Sometimes it may seem like a formality or a waste of time, but documentation is essential. In the case of disputes, a written document can be a strong case in your favor.
An LLC must keep copies of the following papers:
- Formation documents;
- Annual reports;
- Tax documents;
- Operating agreement (preferably).
4) Can Be Uninviting to Investors
If you choose between a sole proprietorship or partnership and an LLC, the latter has a distinct advantage when it comes to attracting investments. The investors feel more comfortable investing in limited liability companies, because they are more stable and respectable.
Nevertheless, there is a nuance. Because an LLC is not selling membership shares like a corporation, venture capital can only be invested by joining its membership. This requires a bit more formality than purchasing shares, so it does not fit all investors.
Should I Hire Someone to Help Form My LLC?
When you start forming your own limited liability company, you will be probably into planning, and dealing with the paperwork can be a real headache. Fortunately, you don’t have to open an LLC on your own.
There are several ways to hand over some of the responsibility for the LLC formation process to the professionals. Each option has its pros and cons, so it’s impossible to say definitively which one is better. All businesses are unique, so you should make your decision based on the specifics, goals and financial capacity.
For example, you can hire a lawyer or accountant, and delegate the paperwork to him. Since the services of specialists are expensive, hiring an online LLC formation service is becoming more and more popular today.
Cooperating with an online company professionally involved in the creation of a new business gives a number of advantages. One of them is saving money. Hire online companies are cheaper than the attorney’s services, so you will save several hundred dollars.
Furthermore, many services not only professionally form an LLC, but also offer useful additional features.
If you don’t know yet what company to choose, take a look at the two most popular options.
The company has a large amount of positive customer feedback and years of experience, making it the top choice for LLC formation in the industry.
If you choose this company, the cost of opening an LLC will be $99+state fee. Although this is more expensive than some competitors, LegalZoom offers plenty of advantages that make this price justified. For example, their 100% satisfaction guarantee.
In addition, LegalZoom has impressive customer volume and unrivaled brand power based on an impeccable reputation.
There is no universal structure that is ideal for all types of businesses. When choosing the type of future business structure, there are many factors to consider, such as:
- Development stage;
- Business goals;
- Peculiarities of this industry, etc.
Of course, this structure is not for all entrepreneurs, but LLC advantages are obvious. The main ones are the following:
- Simple formation and relatively low fees;
- Personal asset protection, which ensures the safety of the owners’ personal property;
- Flexible management and taxation.
Remember that the decision to choose to start an LLC include not only the pros but also the cons. The most obvious disadvantages of forming an LLC are:
- Obligation to pay self-employment taxes;
- Responsibility to handle the paperwork and submit regular reports;
- Difficulty of attracting investors.